By Isabel Morales
Latin America is a region that has long suffered in maintaining sustained economic growth. It struggles to find ideal policies and solutions for its development and has undergone several periods of crisis while attempting to experiment with an array of these policies. Discussions carried out by economists regarding Latin America’s economic growth have focused on the topic of financing development. For instance, Joshua Aizenmann focuses on the overvaluation of Latin America’s external financing by looking at self-financing ratios and their relationship to growth. Self-financing ratios are the share of domestic capital that is financed by domestic savings, without relying on external borrowing (Aizenmann 2005). On the other hand, research by Jose Antonio Ocampo and Daniel Titelman centers on the need for strong regional financial cooperation that provides a layer of support in times of crisis (Ocampo & Titelman, 2012). However, when considering these two viewpoints, we can observe how they may complement each other and show the complexities of achieving development in Latin America. Ocampo and Titelman mention that development may be carried out by enacting policies that work on strengthening the regional financial cooperation system. Yet, the effectiveness of this also requires considering the points in Aizenmann’s research about reforming deeper fiscal deficiencies so countries can benefit from external capital. In other words, external financing is certainly needed to an extent to push Latin America’s development, considering it provides substantial support, yet it must complement regional financial cooperation. For this to be effective, fiscal policy reforms must take place for growth to be achieved under a regional cooperation framework.
Ocampo and Titelman’s research mention an “international financial architecture”. This is a network of global, regional, and subregional institutions where external financing from sources like global institutions complement regional institutions and development banks to help countries in times of crisis and needed development (Ocampo & Titelman, 2012). During times of world crises is when we can observe Latin American countries’ vulnerability to external shocks and the dependence on foreign capital. An example of this is when Mexico defaulted in the 1980s (Sims, 2013). A contraction followed in other Latin American countries, leading to the borrowing and lending of international capital. Due to this dependency and vulnerability, individual countries have resorted to what is known as a “self-insurance” method, where they accumulate foreign exchange reserves. These reserves are assets held by a central bank in foreign currencies. They serve many purposes but are mostly used to ensure that a central government agency has backup funds if their national currency devalues (Hargrave, 2022). To an extent, accumulating foreign reserves can be beneficial in tackling crises, but is not the most efficient option. This is especially true in the case of smaller countries, because it is more difficult for them to accumulate reserves, making their strategy to combat shocks extremely limited (Ocampo & Titelman, 2012). Thus, regional financial institutions are extremely important and have been effective for the most part. According to Ocampo and Titelman, a regional fund like The Latin American Reserve Fund (FLAR), plays a role in the balance of payments support, has some of the best credit ratings in Latin America, and has surpassed global institutions like the IMF in financing during several periods of crisis—showing the importance of regional institutions (Ocampo & Titelman, 2012).
Therefore, a regional monetary cooperation framework can offer additional support in times of crisis because there is assistance from countries within the region without the dependence on external financing. This is especially important because in many cases, external financing may not be accessible or may have a negative impact on growth. For instance, Aizenmann states that external assistance is often overrated. He starts his analysis of external financing by describing Latin America’s shift to financial liberalization in the 1990s. The optimism and lure for external financing is related to the thought that more capital would reduce the scarcity of domestic savings, increase investment, and lead to overall growth (Aizenmann 2005). Yet, in the 1990s, Aizenmann shows that countries that relied more on local or self-financing in the 1990s had higher growth rates than those that relied on external financing. This trend is demonstrated through an equation focusing on what is called the self-financing ratio. Aizenmann uses Chile as an example of this phenomenon by showing that its self-financing ratio of 0.95 was a factor that led to its impressive average growth rate of GDP per capita of more than 4 percent. Its self-financing ratio of 0.75 in 1984 was consistent with its financial crisis and depression. This ratio then increased to 0.96 in 1992, shifting Chile’s economy towards recovery (Aizenmann, 2005). Yet, the success of self-financing does not always guarantee sustained growth and it depends on factors such as credibility and stronger governance, which holds for external financing as well.
Besides the possibility of self-financing leading to growth, Aizenmann argues that external financing might be overvalued due to the lack of accelerated growth Latin American countries experienced with financial liberalization. As previously mentioned, there are several advantages to financial opening like yielding greater financial depth and increasing financial savings for investment, but it is difficult to only observe these advantages in developing countries like those in Latin America where institutions and financial markets are not strong enough to handle the structural changes of liberalization (Martínez & Martínez, 2014). Therefore, these countries are more vulnerable to the negative effects of financial openness that could potentially lead to a financial crisis. According to Aizenmann, “the challenge is to design a liberalization program that does not bring a crisis in its wake (Aizenmann 2005). Thus, the growth effects of liberalization are stronger in countries that have strong institutions, which could be a reason why Aizenmann claims that external financing in Latin America is overrated.
Political instability tends to cause a lack of credibility among investors, which leads to consumers being more cautious in increasing their saving and investment rates. Following this idea of the absence of strong institutions hindering external financing, there must be a priority in carrying out fiscal reforms. In many circumstances, Latin America has focused on finding the best monetary policies that will support growth, such as the accumulation of foreign reserves. Though seeking efficient monetary policies is certainly important, this usually comes at the cost of not emphasizing the need to challenge deeper fiscal deficiencies (Aizenmann 2005). For example, both Brazil and Argentina went through successful exchange rate-based stabilizations in the early nineties by pegging the exchange rate as Colombia initially did. However, Argentina continued to focus on monetary policies while Brazil put more effort into dealing with its fiscal imbalances (Fishlow, 1990). This allowed Brazil to steer away from a deep crisis, whereas Argentina’s choice created vulnerability and led to its ultimate recent crisis (Aizenmann 2005). In a paper by economist Albert Fishlow, one of the main problems Latin American countries faced in the 1980s was the inadequacy of fiscal policy, which made it harder for Latin American countries to adjust to less favorable external conditions (Fishlow, 1990). This same idea still applies nowadays.
The strengthening of structural and fiscal policies is crucial for financing development in Latin America through a regional financial cooperation system. Without fiscal reforms, several countries simply do not have the means to contribute to regional financial support, which makes this mechanism fail. This may seem obvious, but the case of Argentina is a good example of this. Argentina’s previous sustainable growth ended in 1974 as a result of fiscal irresponsibility, when the government had access to financing yet borrowed beyond the sustainable level and caused periods of severe recessions. For the past decades, Argentina’s economy has been characterized by incessant inflation and debt and has been forced to ask the IMF for aid several times (Sullivan, 2020). So, because Argentina is dealing with alarming fiscal problems and massive debt, the efficacy of a regional reserve fund decreases because it is a country that had the capacity to support smaller countries in times of crisis, but it is now unable to because of domestic issues. Without institutional reforms that lead to a fiscal restructuring in countries like Argentina and others that are currently undergoing extreme financial instability, the possibility of enhanced growth is hindered.
There are several obstacles and different components impeding the effectiveness of a regional financial cooperation system for financing Latin American development. A regional framework is also crucial to enhance the work of global institutions and external financing sources that can complement regional financing in providing aid, giving countries more security in times of external shocks. External financing is, therefore, necessary to an extent in given situations, but should not be a source of dependency as it can be detrimental to growth. Finally, for regional cooperation to work smoothly, countries must focus on reforming their monetary and fiscal policies equally, given inadequate fiscal situations that prevent regional cooperation strategies from performing successfully.
Aizenmann, J. (2005). Financial Liberalization in Latin America in the 1990s: A Reassessment. National Bureau of Economic Research. https://canvas.pitt.edu/courses/77347/files/4445513?module_item_id=1884506
Fishlow, A. (1990). The Latin American State. Journal of Economic Perspectives. https://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.4.3.61
Hargrave, M. (2022, February 15). Foreign Exchange Reserves Definition. Investopedia. https://www.investopedia.com/terms/f/foreign-exchange-reserves.asp
Martínez, N., & Martínez, S. (2014). Análisis de las ventajas y desventajas que se pueden generar dentro del sistema financiero bancario colombiano por la suscripción de tratados de libre comercio en Colombia. Pontificia Universidad Javeriana. https://repository.javeriana.edu.co/bitstream/handle/10554/34397/MartinezMartinezNatalia2015.pdf?sequence=5&isAllowed=y
Ocampo, J. A., & Titelman, D. (2012). Regional Monetary Cooperation in Latin America. ADBI Institute. https://www.adb.org/sites/default/files/publication/156228/adbi-wp373.pdf
Sims, B. J. (2013). Latin American Debt Crisis of the 1980s. Federal Reserve History. https://www.federalreservehistory.org/essays/latin-american-debt-crisis#:%7E:text=The%20spark%20for%20the%20crisis,at%20that%20point%20totaled%20%2480
Sullivan, A. (2020, August 4). Don’t pay me back, Argentina. DW.COM. https://www.dw.com/en/argentinas-debt-restructuring-deal-explained/a-54432373